Thursday, July 09, 2009

Banks Do Not Keep Reserves

by Arian Forrest Nevin, JD

Contrary to widely held belief, banks, not the government, create money. It is also widely believed that banks practice "fractional-reserve lending". This is totally false. Banks do not keep reserves. Not only do banks not keep reserves it is impossible for them to do so.

Money comes in two separate and distinct types. One type everyone is familiar with is physical, which is cash. The second type is purely electronic, and exists solely within a bank's computer. The kind of money created by commercial banks is of the second type, electronic. Most people believe that banks keep a "reserve" of cash to back the electronic money that they create. This is untrue and impossible. A reserve of money cannot be kept to back money. A reserve of oranges cannot be kept to back other oranges. Dollar bills cannot be backed by a reserve of quarters. A reserve of the same thing cannot be kept to back the very same thing. Money is money. Banks do not create money based on a reserve of money they keep. Banks create money based on a legal reference, not a reserve. Just as at Walmart there may be a sale where you "buy one and get two free". Walmart is using a reference that says if you purchase one then you get two more for free. There is no reserve. Similarly, banks reference a rule to determine how much money they can create. For any amount of money on deposit with a bank that bank is allowed to create 90% of that amount as new electronic money. So if I deposited $100 at Bank of America, then based on the legal reference banks use, Bank of America would be allowed to create $90 new dollars. As you can see there is no reserve involved in the process of money creation by banks.

Banks are not legally required to keep any cash whatsoever. In fact, to meet the requirements of the legal reference banks can keep an account of electronic money with a Federal Reserve Bank. Banks do not need to keep any cash on hand. In practice, banks keep enough cash on hand to meet their customers' demands for withdrawals of cash. This is no different than any other operational stockpile kept by a business. McDonalds keeps enough french fries on hand so that they will not run out.

All of the money that is supposed to be in a bank is there all of the time. One might then wonder, what is a run on a bank if all of the money is there? Quite simply, as there are two kinds of money, the total amount of money that exists at any given time is greater than the amount of either physical or electronic money individually. Thus, if everyone wanted to only possess one-dollar bills and not five or ten-dollar bills, this would be impossible because the total amount of cash is greater than the amount of one-dollar bills. Similarly, it is impossible for everyone to possess all of their money as cash at the same time, because the total amount of cash is less than the total amount of the two types of money. Banks have all the money they are supposed to have at all times. It is just that some of it is cash and some of it is electronic.

At any given time an individual bank may have created the maximum total amount of money it is allowed to create. However, the aggregate of all banks will always have created less money than they could. For the past forty years banks have created nearly the maximum possible amount of money. On average, during the past forty years banks have created about ten billion dollars less than they were legally allowed to. In the past three months this amount has exploded. As of November 1st 2008, the amount of money banks are choosing not to create has gone from the average of about ten billion to over five trillion dollars. This is 56 times greater than what it has been on average for the past forty years. Yet at the same time we have a "credit crunch". Banks are quite capable of creating and loaning more money; they could lend over five trillion dollars. They simply choose not to.